Implications of Costly Information

Traditional economic analyses often begin with an assumption that people have all of the knowledge necessary to make fully-informed decisions. Everyone has all of the relevant information, everyone knows that everyone has that information, and so on. This is a simplifying assumption, not accurately reflecting the real world, but making it easier to highlight other features of market transactions. Classical economists acknowledged that this is a strong assumption, and though they did make references to how differences in information could cause disparate economic outcomes, twentieth century economists made additional important contributions to our understanding the role of information.

The Optimal Amount of Information

Through the process of selecting menus for an upcoming reception, I have come to realize that I know essentially nothing about wine. I can taste a couple of glasses and tell you which one I like more, but anything beyond that, like knowing whether this merlot or that cabernet sauvignon would go better with which proposed entree, and you might just as well give me a coin to flip. The information is out there—there are books, wine-tasting clubs, and the like—but I don't have it. What's more, I am not going to get it, even though doing so would improve the selections I make and so enhance the pleasure of the guests at the reception.

The reason is that information about wine or any other subject is costly to acquire. Time, effort, and resources must be devoted in order to locate, gather, and assimilate information. In this respect, information is a good, and people need to decide how much of their resources they want to devote to acquiring it, just like they need to decide how much to spend on housing, cookies, swimming lessons, and everything else. Because information is costly, there is so much of it out there, and people have so many other desires beside acquiring information, they are not likely even to be able to approach full and perfect knowledge on any subject. As British economist Nassau W. Senior wrote in Chapter 2, paragraph 31 of Political Economy (1854), "The details of commerce are so numerous, the difficulty of obtaining early and accurate information is so great, and the facts themselves are so constantly changing, that the most cautious merchants are often forced to act upon very doubtful premises." To continue with my example, if I were to know everything about wines, I would need to learn about thousands of vineyards, their different soils, climates, and histories, and I would need to revise this information every year as new vintages arise.

Importantly, though, even if a some people have the capacity to maintain such a mass of information, nobody should really want to know that much about a subject. Very few of us ever make decisions that require such detailed knowledge. In my case, I just need to figure out what would go nicely with a steak in mushroom sauce. If I were to learn so much about wine that I knew which years were particularly good for chardonnays produced in New South Wales, I probably would have acquired far more information than I need. At that point, any resources spent locating and learning additional information would yield little or no benefits. In fact, I likely would have been far better off if I had spent some of the time and effort that I put into learning those details doing something else instead. James M. Buchanan had just this point in mind in paragraph 13 of the Introduction to Public Finance in Democratic Process: Fiscal Institutions and Individual Choice.

Individuals are not, of course, omniscient, even those who think themselves to be. The securing of information about the predicted effects of alternatives is a costly process, even in a world with reasonable certainty. Recognizing this, individual utility-maximizing behavior remains "rational" when choices are made on the basis of less-than-perfect information. There is some "optimal" investment in fact-finding and analysis for the deciding individual at each stage of his deliberation.

Buchanan's use of the word "investment" is suggestive, in that information is mainly a factor of production, an input used to make decisions. (Information can be a final good as well, in that people do derive some satisfaction simply from knowing things, but its more interesting role in economics is as an input.) Just as an appliance manufacturer can make refrigerators using more or less steel, a consumer (or producer, for that matter) can make decisions using more or less information. A refrigerator with less steel may be cheaper to make but also may be smaller or less durable, while at some point adding more and more steel to a refrigerator just makes its cost rise and yields no additional benefits—there is a trade-off. Analogously, a decision can be made more quickly and cheaply if less information is sought and used, but the outcome of that decision may not be as beneficial as it could have been. Too much information, as described above, can be wasteful as well. Also, resources that a manufacturer spends acquiring more steel cannot be used to supervise actual production. The more time and effort that is spent acquiring information, the less time there is available to process that information in order to come to a decision. The optimal amount of information in any given situation will depend on the decision to be made, the costs of acquiring information, and most importantly on the preferences of the individual who must decide.

Problems of Asymmetric Information, and Solutions

Given that the choice of how much information a person acquires is based on his or her own unique preferences and resources, it is not surprising that there are great differences, or asymmetries, in the amount of information people have about any given market. Further, it is to be expected that individuals whose livelihood depends on their chosen industry often possess the most information in that field.

Economists have long acknowledged that people acquire information in accordance with their careers. Jeremy Bentham extolled "the superior fitness of individuals for managing their own pecuniary concerns, of which they know the particulars and the circumstances" in paragraph 13 of his letter to Adam Smith, in his Defence of Usury (1818, first pub. 1787).

More explicit with regard to occupations, Alfred Marshall wrote in Book IV, Chapter 9, paragraph 3 of Principles of Economics (1920, first pub. 1890), that

The mind of the merchant, the lawyer, the physician, and the man of science, becomes gradually equipped with a store of knowledge and a faculty of intuition, which can be obtained in no other way than by the continual application of the best efforts of a powerful thinker for many years together to one more or less narrow class of questions.

Such a concentration of information in the hands of some market participants can cause significant discrepancies between actual outcomes and the outcomes predicted under an assumption of full and complete information among everyone concerned. Classical economists were well aware of one such discrepancy two hundred years ago. Another, however, was only expounded upon in the last few decades. Let's address the older topic first.

Asymmetric Information in Production—Secrecy

Under an assumption of full and complete information, all producers of a given commodity know the best available techniques for producing it. In order to compete for customers who want the commodity at the lowest possible price, the producers are forced to all use the most cost-effective technique and set a price that only just compensates them for their costs.

In reality, however, a producer can, by good fortune or good design, acquire "inside information" allowing him to improve his own production techniques without his rivals knowing it, making it cheaper for him to produce the same good. When that occurs, the better-informed producer is able to continue charging the old price, but with each sale reap higher profits than can any other producer, something that would be impossible without the asymmetry of information. Because of the opportunity for high profits, the producer wants to keep his information secret for as long as he can. French economist Jean-Baptiste Say described the gains to be made for such secret information in Book II, Chapter 2, paragraph 16 of A Treatise on Political Economy (1855):

Every saving in the charges of production, that is to say, every saving in the productive agency exerted to raise the same product, is an increase of the revenue of the community to an equal extent; as, for example, the contrivance to raise as much upon one acre of land as before upon two, or to effect with two days' labour, what before required as much as four; for the productive agency thus released may be directed to the increase of production. And this accession of revenue will accrue to the individual benefit of the contriver, so long as the contrivance can be confined to his own knowledge....

A few years earlier, Say's countryman Frederic Bastiat supposed that some clever producer alone discovered how to harness the power of a natural force like gravity to reduce production costs, and kept this new information secret. From Chapter 10, paragraph 36 of Economic Harmonies (1850):

His demands in this respect would go as high as the point at which they would impose on the consumers a greater sacrifice than the old method would entail. He may have succeeded, for example, in eliminating nine-tenths of the labor required for producing article x. But at the present time x has a current market price that has been established by the pains it takes to produce it in the ordinary way. The inventor sells x at the market price; in other words, he is paid ten times more for his pains than are his competitors. This is the first phase of the invention.

As a result of the asymmetric information that the producer has over his rivals, consumers would pay significantly more for article x than it now costs to produce it. This result, which contradicts the full information market outcome, would not, in Bastiat's analysis, last long. The generation of higher profits would inevitably draw attention to the advantaged producer, and the additional knowledge he has would with time become more widely known. From paragraphs 39 and 40:

At this juncture, however, the invention enters its second phase, the phase of imitation. Excessive compensations by their very nature arouse covetousness. The new process spreads, the price of x steadily drops, and the remuneration also declines, more and more rapidly as the time interval between the invention and its imitations lengthens, that is, as it becomes easier and easier, and less and less risky, to copy the invention, and consequently less and less worth while....

At last the invention reaches its third and final phase, the phase of universal distribution, where it is common property, and free of charge to all.... The utility of article x remains the same; but nine-tenths of it have been supplied by gravitation, which was originally common to all in theory, and has now become common to all in fact in this special application. This is proved by the fact that all consumers on the face of the earth may now buy article x for one-tenth of what it once cost them.

Adam Smith, too, described how secret knowledge of improved production techniques could generate high profits for a producer for some time. He also explicitly noted that as the cost to potential rivals of discovering the inside information rose, the longer the producer would be likely to maintain his high profits. In paragraph 21 of Book I, Chapter 7 of An Inquiry into the Nature and Causes of the Wealth of Nations (1904, first pub. 1776), he wrote that

If the market is at a great distance from the residence of those who supply it, they may sometimes be able to keep the secret for several years together, and may so long enjoy their extraordinary profits without any new rivals. Secrets of this kind, however, it must be acknowledged, can seldom be long kept; and the extraordinary profit can last very little longer than they are kept.

In the case of secrecy in production, then, there is no need for any outside arrangement to be created to resolve the problem generated by the information asymmetry, despite the fact that the producer wants to keep his information secret. The presence of high profits acts as a signal to rival producers not only that valuable new information exists, but also where it is located. The self-interest of those other producers leads them to acquire the new information, and an outcome more in keeping with the full information assumption occurs.

Asymmetric Information in Quality—The Market for Bad Wine

In his 1970 paper "The Market for 'Lemons': Quality, Uncertainty and the Market Mechanism," George A. Akerlof described another problem resulting from information asymmetry, this time involving information regarding the quality of a product.1 What follows is a very simplified version of his analysis, this one focusing on wine rather than used cars, as Akerlof did.

Imagine that a bottle of wine can be of either good quality or bad quality, and that it costs $40 to produce a bottle of good wine but only $15 to produce a bottle of bad wine. Now let's assume that I would be willing to pay $50 for a good bottle of wine to serve at my reception, but a bad bottle is worth nothing, $0, to me.

In a world in which everyone knows all of this information, if I found a wine-maker with a bottle of good wine, we would be able to negotiate a price somewhere between $40 and $50 for it, and we would make the exchange. To be more precise, our exchange would generate $10 of surplus that we would split between us. To see how, suppose we settled on a price of $44. Then the wine-maker would get a surplus of $4 ($44 minus his costs of $40) while I would get a surplus of $6 (the $50 the bottle is worth to me minus the $44 that I paid for it). For any other price between $40 and $50, the total surplus would still be $10, even though it would be split differently between the wine-maker and me.

What would happen in a world of asymmetric information? Specifically, suppose that I, having no specialized knowledge of wine, could not tell whether a bottle is good or bad until after I bought it, opened it and drank it. Because I would have no way of knowing what I was buying until it was too late, a wine-maker could try to sell me a bottle of bad wine, which cost him less to make, by lying to me, telling me that it is good wine. If I fell for it, and agreed to pay $44 for it, then the wine-maker would get a surplus of $29 ($44 minus his costs of $15), while I would be stuck with a negative surplus (that is, a deficit) of $44 (the $0 the bottle is worth to me minus the $44 that I paid for it)!

Considering this, I would recognize that any wine-maker would rather have a surplus of $29 rather than one of $4, and would worry that any wine-maker I found would rather sell me a bottle of bad wine than a bottle of good wine. My choice then would become that between being cheated by buying a bottle of bad wine for a deficit of $44, or not buying any wine and breaking even. Faced with this choice, I would not buy any wine, and my surplus and the wine-maker's would both be zero. This would be the result, even though both of us would be better off if we could agree to exchange a bottle of good wine for a combined surplus of $10. As a result of the information asymmetry, a beneficial exchange would not occur. This is contrary to the prediction of what would occur under full and complete information.

An interesting feature of this scenario is that unlike the producer enjoying secrecy in production, who was better off the longer he maintained his asymmetry in information, the wine-maker here would be better off if the asymmetry did not exist. If there were a way for him to communicate his information to me so that I could know what quality of wine he was offering, then he could make a sale.

Because there are gains to be realized from eliminating the information asymmetry, society can be made better off if arrangements to facilitate that service arise. In paragraph 43 of Part III, Chapter 8 of Risk, Uncertainty, and Profit (1921), Frank H. Knight recognized how both private and public institutions emerged to handle the dissemination of information:

Not merely do the market associations or exchanges and their members engage in this work on their own account. Its importance to society at large is so well recognized that vast sums of public money are annually expended in securing and disseminating information as to the output of various industries, crop conditions, and the like. Great investments of capital and elaborate organizations are also devoted to the work as a private enterprise, on a profit-seeking basis, and the importance of trade journals and statistical bureaus and services tends to increase, as does that of the activities of the Government in this field. The collection, digestion, and dissemination in usable form of economic information is one of the staggering problems connected with our modern large-scale social organization.

When governments do get involved, they raise the possibility that political considerations will impede the economic goal of reducing information asymmetries. Inherent to Enron's demise, for example, was the failure of external audits to fulfill their main purpose, reducing the information asymmetry between company executives and shareholders. In "Enron's True Lesson: Political Opportunism," Fred McChesney explains why the politics on display after Enron collapsed was about something other than reducing information asymmetries.

Although governments often do get involved with reducing information asymmetries, the above example shows how private enterprise can find solutions without the need for state interference. We have seen that if the wine-maker and I can agree to the sale of a bottle of good wine, there will be $10 of surplus generated. If an entrepreneur can establish himself as a disinterested, credible, third-party resource for identifying the quality of wine prior to its purchase, and is able to provide that service for under $10, then we will be able to make the transaction and enjoy some surplus. For instance, if the entrepreneur were to charge $8 for his service, the wine-maker and I could agree to a price of $41, with me also paying the entrepreneur. I would receive a surplus of $1 ($50 - $41- $8 = $1), as would the wine-maker ($41 - $40 = $1), and the entrepreneur would either break even or receive some surplus, depending on whether his costs were equal to or less than his $8 fee. The predicted result under full and complete information, that mutually beneficial gains from trade would be realized, would occur, without the state needing to be involved.

In both cases of information asymmetry, the complications that arose as a result of people having different levels of information were resolved, and resolved by market forces rather than government intervention. This column began with the premise that information is costly, and that people can have good reasons not to acquire it. What the two cases of information asymmetry have hopefully shown is that if there are gains to be had by the dissemination of information, then that information will be spread, and spread by people acting of their own accord and in their own self-interest.

Next Time

There is one more aspect to the role of information in economics, and it is much more fundamental and encompassing than those described above. In the next Teacher's Corner, we will examine the inextricable connection between information and prices. This connection is essential to understanding the importance of prices in economics. It was also one of the major battlegrounds in the intellectual struggle between capitalism and socialism.